GUIDING PRINCIPLES ON LIQUIDITY RISK MANAGEMENT FOR INSTITUTIONS OFFERING ISLAMIC FINANCIAL SERVICES [EXCLUDING ISLAMIC INSURANCE ( TAK

Transcription

1 IFSB-12 GUIDING PRINCIPLES ON LIQUIDITY RISK MANAGEMENT FOR INSTITUTIONS OFFERING ISLAMIC FINANCIAL SERVICES [EXCLUDING ISLAMIC INSURANCE (TAKĀFUL) INSTITUTIONS AND ISLAMIC COLLECTIVE INVESTMENT SCHEMES] March 2012

2 COUNCIL MEMBERS* H.E. Rasheed Mohammed Al Maraj H.E. Dr Atiur Rahman H.E. Haji Mohd Rosli bin Haji Sabtu H.E. Djama Mahamoud Haid H.E. Dr Farouk Abd El Baky El Okdah H.E. Dr Ahmad Mohamed Ali Al Madani H.E. Dr Darmin Nasution H.E. Dr Mahmud Bahmani H.E. Dr Ziad Fariz H.E. Dr Mohammad Y. Al Hashel H.E. Dr Zeti Akhtar Aziz H.E. Fazeel Najeeb H.E. Rundheersing Bheenick H.E. Sanusi Lamido Aminu Sanusi H.E. Yaseen Anwar H.E. Sheikh Abdullah Saoud Al-Thani H.E. Dr Fahad Al-Mubarak H.E. Ravi Menon H.E. Dr Mohamed Khair Ahmed Elzubear H.E. Sultan Bin Nasser Al Suwaidi Governor, Central Bank of Bahrain Governor, Bangladesh Bank Managing Director, Autoriti Monetari Brunei Darussalam Governor, Banque Centrale De Djibouti Governor, Central Bank of Egypt President, Islamic Development Bank Governor, Bank Indonesia Governor, Central Bank of the Islamic Republic of Iran Governor, Central Bank of Jordan Governor, Central Bank of Kuwait Governor, Bank Negara Malaysia Governor and Chairperson, Maldives Monetary Authority Governor, Bank of Mauritius Governor, Central Bank of Nigeria Governor, State Bank of Pakistan Governor, Qatar Central Bank Governor, Saudi Arabian Monetary Agency Managing Director, Monetary Authority of Singapore Governor, Central Bank of Sudan Governor, Central Bank of the United Arab Emirates *In alphabetical order of the country the member represents i

3 TECHNICAL COMMITTEE Chairman Dr Abdulrahman A. Al-Hamidy Saudi Arabian Monetary Agency Deputy Chairman Mr Osman Hamad Mohamed Khair Central Bank of Sudan (until 15 August 2009) Dr Mohammad Yousef Al Hashel Central Bank of Kuwait (from 23 November 2009) Dr Sami Ibrahim Al-Suwailem (until 13 December 2010) Dr Salman Syed Ali (from 14 December 2010) Mr Khalid Hamad Abdulrahman Hamad Mr Gamal Abdel Aziz Ezzat Negm (until 13 December 2010) Mr Farag Abdul Hameed Farag (until 17 November 2011) Mr Tarek Hashem Fayed (from 18 November 2011) Mr Ramzi Ahmad Zuhdi (until 5 April 2010) Dr Mulya Effendi Siregar (from 6 April 2010) Mr Hamid Tehranfar (until 31 March 2009) Mr Abdolmahdi Arjmand Nejad (from 1 April 2009) Mr Bakarudin Ishak (until 31 March 2009) Mr Ahmad Hizzad Baharuddin (until 17 November 2011) Mr Bakarudin Ishak (from 18 November 2011) Dr Nik Ramlah Mahmood Dr Bashir Umar Aliyu (from 6 April 2010) Mr Pervez Said (until 31 March 2009) Ms Lubna Farooq Malik (until 5 April 2010) Mr Saleemullah (from 6 April 2010) Mr Mu jib Turki Al Turki Mr Chia Der Jiun (until 13 December 2010) Mr Adrian Tsen Leong Chua (from 14 December 2010) Mr Mohammed Ali Elshiekh Terifi (until 30 March 2011) Mr Mohamed Hassan Alshaikh (from 31 March 2011) Mr Saeed Abdulla Al-Hamiz (until 31 March 2009) Mr Khalid Omar Al-Kharji (from 1 April 2009) Members* Islamic Development Bank Islamic Development Bank Central Bank of Bahrain Central Bank of Egypt Central Bank of Egypt Central Bank of Egypt Bank Indonesia Bank Indonesia Central Bank of the Islamic Republic of Iran Central Bank of the Islamic Republic of Iran Bank Negara Malaysia Bank Negara Malaysia Bank Negara Malaysia Securities Commission of Malaysia Central Bank of Nigeria State Bank of Pakistan State Bank of Pakistan State Bank of Pakistan Qatar Central Bank Monetary Authority of Singapore Monetary Authority of Singapore Central Bank of Sudan Central Bank of Sudan Central Bank of the United Arab Emirates Central Bank of the United Arab Emirates * In alphabetical order of the country the member s organisation represents ii

4 LIQUIDITY RISK MANAGEMENT WORKING GROUP Chairmen Dr Salman Syed Ali Islamic Development Bank (October 2011 to date) Mr Ahmad Hizzad Baharuddin Bank Negara Malaysia (February 2011 September 2011) Dr Sami Ibrahim Al-Suwailem Islamic Development Bank (May 2010 January 2011) Deputy Chairmen Dr Salman Syed Ali Islamic Development Bank (February 2011 September 2011) Mr Ahmad Hizzad Baharuddin Bank Negara Malaysia (May 2010 January 2011) Dr Sami Ibrahim Al-Suweilam Ms Hana Ahmed Al-Murran Mr Muhamad Irfan Sukarna Mr Abdullah Khalid Al-Terkait Ms Joelle El Gemayel Mr Elie Flatter Ms Nurhayati Mohd Khalid Mr Mohd Radzuan Ahmad Tajuddin Dr John Lee Hin Hock Mr Muhammad Wada Muazu Lere Mr Usman Abdulqadir Ms Nighat Tanveer Mr Adel Al Baker Mr Faisal Al-Mannai Mr Adel Al Khaleifi Mr Fahad Alhumaidah (until June 2011) Mr Talal Al-Humoud (from June 2011) Mrs Asmaa Abdelrahman Khairi Mr Adel Al Saygh Mr Prasanna Seshachellam Members* Islamic Development Bank Central Bank of Bahrain Bank Indonesia Central Bank of Kuwait Banque Du Liban Banque centrale du Luxembourg Bank Negara Malaysia Securities Commission of Malaysia Maybank Group, Malaysia Central Bank of Nigeria Central Bank of Nigeria State Bank of Pakistan Qatar Central Bank Qatar Central Bank Saudi Arabian Monetary Agency Saudi Arabian Monetary Agency Saudi Arabian Monetary Agency Central Bank of Sudan Central Bank of United Arab Emirates Dubai Financial Services Authority, United Arab Emirates * In alphabetical order of the country the member s organisation represents iii

5 SHARĪ`AH COMMITTEE FOR ISLAMIC DEVELOPMENT BANK GROUP* Chairman Sheikh Dr Hussein Hamed Hassan (from15 February 2012) Sheikh Mohamed Mokhtar Sellami (until 14 February 2012) Deputy Chairman Sheikh Dr Abdulsattar Abu Ghuddah (from 15 February 2012) Sheikh Saleh Bin Abdulrahman Bin Abdulaziz Al Husayn (until14 February 2012) Sheikh Mohamed Mokhtar Sellami H.E. Sheikh Abdullah Bin Suleiman Al- Mani Sheikh Muhammad Taqi Al-Usmani Sheikh Mohammad Ali Taskhiri Sheikh Mohamed Hashim Bin Yahaya * In alphabetical order Member Member Member Member Member SECRETARIAT, ISLAMIC FINANCIAL SERVICES BOARD Professor Datuk Rifaat Ahmed Abdel Karim Secretary-General (until April 2011) Mr Jaseem Ahmed Secretary-General (from May 2011) Professor Simon Archer Consultant Dr Hennie van Greuning Consultant Mr Zahid ur Rehman Khokher Member of the Secretariat, Technical and Research iv

6 Table of Contents ACRONYMS...vii SECTION I: BACKGROUND AND INTRODUCTION Background, Purpose and Objectives Scope and Application of the Standard Implementation Timeline Previous IFSB Publications and Initiatives...3 SECTION II: LIQUIDITY RISK AND NECESSARY ELEMENTS FOR ITS EFFECTIVE MANAGEMENT IN THE IFSI Liquidity Risk and Liquidity Risk Management Necessary Elements of Effective Liquidity Risk Management in the IFSI Executive Summary of the Guiding Principles...8 SECTION III: GENERAL AND GUIDING PRINCIPLES FOR THE IIFS General Principle...12 Principle Role of the Board of Directors...14 Principle Governance Structure and the Role of Senior Management...15 Principle Identification of Liquidity Risk...17 Principle Interactions of Liquidity Risk and Implications of Islamic Financing Contracts...20 Principle Measurement of Liquidity Risk...22 Principle Control and Mitigation of Liquidity Risk...25 Principle Principle Principle Principle Principle Principle Principle Foreign Exchange Liquidity Risk...37 Principle Reporting and Disclosure of Liquidity Risk...39 Principle v

7 SECTION IV: GUIDING PRINCIPLES FOR SUPERVISORY AUTHORITIES Responsibility for Supervision of Liquidity Risk and Position...42 Principle Need for Supervisory Regulations for IIFS...43 Principle Supervisors Role as Provider of Liquidity Support...45 Principle Supervision of Liquidity Risk at Consolidated Level...46 Principle Compilation of Information about Liquidity and Corrective Action...48 Principle Home-Host and Cross-Sector Supervision of Liquidity Risk...49 Principle Supervisors Contingency Planning for the IIFS...50 Principle Supervisors Role in the Development of Liquidity Infrastructure...51 Principle DEFINITIONS...53 APPENDIX: SUGGESTED METRICS AND MONITORING TOOLS...56 vi

8 ACRONYMS ALCO ALM BCBS CEBS CFP CMT CRO EBA ERM FTP GN HLTF IAH IDB IFSB IFSB-1 IFSB-4 IFSB-5 IFSB-10 IFSB-13 IFSB TN-1 IFSB GN-2 IFSB GN-3 IFSI IIFS IILM IMB IOSCO IRR IRTI LCR LOLR MIS NSFR PER PSIA RIAH SPV SSB UIAH Assets and Liabilities Committee Asset liability management Basel Committee on Banking Supervision Committee of European Banking Supervisors Contingency funding plan Commodity Murābahah transactions Chief risk officer European Banking Authority Enterprise risk management Fund transfer pricing Guidance Note High-Level Task Force on Liquidity Management Investment account holders Islamic Development Bank Islamic Financial Services Board Guiding Principles of Risk Management for IIFS Disclosures to Promote Transparency and Market Discipline for IIFS Guidance on Key Elements in the Supervisory Review Process for IIFS Guiding Principles on Sharī`ah Governance Systems for IIFS Guiding Principles on Stress Testing for IIFS Technical Note on Issues in Strengthening Liquidity Management of IIFS: The Development of Islamic Money Markets Guidance Note in Connection with the Risk Management and Capital Adequacy Standards: Commodity Murābahah Transactions Guidance Note on the Practice of Smoothing the Profits Payout to Investment Account Holders Islamic financial services industry Institution(s) offering Islamic financial services (excluding for these Guiding Principles Islamic insurance/takāful institutions and Islamic collective investment schemes) International Islamic Liquidity Management Corporation Ijārah Muntahia Bittamlīk (also known as Ijārah wa Iqtina) International Organization of Securities Commissions Investment risk reserve Islamic Research & Training Institute Liquidity Coverage Ratio Lender of last resort Management information system Net Stable Funding Ratio Profit equalisation reserve Profit-sharing investment account Restricted investment account holders Special purpose vehicle Sharī`ah supervisory board Unrestricted investment account holders vii

9 Bismillahirrahmanirrahim Allahumma salli wasallim ala Sayyidina Muhammad wa ala alihi wasahbihi SECTION I: BACKGROUND AND INTRODUCTION 1.1 Background, Purpose and Objectives 1. Due to the importance of a sound liquidity risk management framework for any well-functioning institution offering Islamic financial services (IIFS), this subject has been addressed in a number of previous Islamic Financial Services Board (IFSB) publications 1 and initiatives. 2 Owing to various constraints on liquidity risk management by IIFS 3 in different jurisdictions, IIFS have often found management of liquidity risk a very challenging part of their operations. These challenges can be observed at all tiers of the liquidity risk management framework of an IIFS institutional, interbank and central bank levels. Accordingly, the potential for cross-border management of liquidity risk by IIFS is even further muted. 2. The global financial crisis, which later transformed into a broad-ranging economic crisis, impacted a large number of financial institutions in both developed and developing economies. Whereas IIFS were largely spared from the initial impacts of the financial crisis due to, among other things, a ban on investments in excessively leveraged financial products and Riba-based equity investments in the form of shares, subsequent tightening of liquidity and credit in the global financial markets adversely impacted a large number of financial institutions, including IIFS. Owing to the growing market share of IIFS in many jurisdictions and their potential significance for systemic soundness and stability of the overall financial system, the need for a robust liquidity risk management framework for IIFS cannot be overemphasised. This phenomenon has led to the growing systemic relevance of IIFS, and to their increasing interaction with other important financial institutions in their jurisdictions. 3. Keeping in view the significance of this subject, the Council of the IFSB, in its 15th meeting in Kuala Lumpur, approved the establishment of a working group to develop a set of Guiding Principles on Liquidity Risk Management for IIFS (hereinafter collectively referred to as the Guiding Principles ). This set of Guiding Principles is intended to provide guidance to IIFS in a number of key areas in their management of liquidity risk, and to facilitate the supervisory authorities assessment of the adequacy of IIFS liquidity risk management framework and levels of liquidity within their constituency. 4. These Guiding Principles endeavour to provide a set of principles for the robust management of liquidity risk by IIFS and its vigorous supervision and monitoring by the supervisory authorities, taking into consideration the specificities of the IIFS and complementing relevant existing and emerging international best practices. This document sets out 23 guiding principles in the area of liquidity risk management for IIFS (excluding (a) Islamic insurance (Takāful) institutions, and (b) Islamic collective investment schemes). Besides providing guidance on prudential aspects related to liquidity risk management in IIFS, this document outlines necessary elements of effective liquidity risk management in the Islamic financial services industry (IFSI). 1 These publications include IFSB-1: Guiding Principles of Risk Management, issued in December 2005, IFSB-IRTI-IDB: Islamic Financial Services Industry Development: Ten-year Framework and Strategies, issued in May 2007, TN-1: Issues in Strengthening the Liquidity Management of IIFS: The Development of Islamic Money Markets, issued in March 2008 and IFSB-IRTI-IDB: Report on Islamic Finance and Global Financial Stability, issued in April See Section 1.4 for further details. 2 Among others, a major initiative by the IFSB Council was the establishment of a High-Level Task Force on Liquidity Management (hereinafter "HLTF") in March 2009, which was the driving force in the setting up of the International Islamic Liquidity Management Corporation (IILM) in November The IILM will issue high-quality benchmark inter-governmental Sukūk that can be traded globally and bring about regional and global integration of Islamic money and capital markets in sovereign issues. 3 These constraints include, inter alia: scarcity of Sharī`ah-compliant instruments; lack of active money market activity in these instruments; insufficient Sharī`ah-compliant mechanisms to mitigate liquidity risk management; insufficient tools available to supervisory authorities for providing liquidity support to IIFS in normal and stressed market conditions; exclusion of IIFS in open market operations for meeting monetary policy objectives, etc. 1

10 1.2 Scope and Application of the Standard 5. This set of Guiding Principles is primarily intended to serve banking institutions offering Islamic financial services. These IIFS include, but are not limited to: fully fledged Islamic commercial banks; Islamic investment banks/companies; Islamic banking subsidiaries of conventional banks; Islamic banking branches/divisions/units of conventional banks (hereinafter collectively referred to as Islamic windows" 4 ); and other Sharī`ah-compliant fund-mobilising institutions, 5 as determined by the respective supervisory authorities. Supervisory authorities shall implement these Guiding Principles with due consideration to proportionality taking account of the size, sophistication and complexity of the IIFS in their market. The principle of proportionality also applies to the size of the Islamic banking industry in the relevant jurisdiction. 6. The Guiding Principles are prepared in line with the objectives of the IFSB to (i) promote the development of a prudent and transparent IFSI through introducing new, or adapting existing, international standards consistent with Sharī`ah principles, and recommending these for adoption; and (ii) provide guidance on the effective supervision and regulation of institutions offering Islamic financial products and to develop for the IFSI the criteria for identifying, measuring, managing and disclosing risks. Consequently, the Guiding Principles will not try to reinvent the wheel, but will endeavour to complement and reinforce the existing internationally recognised standards and best practices for liquidity risk management, while addressing the specificities of the IIFS. 7. The IFSB makes a full acknowledgement of the international efforts to make regulatory reforms at a broader level, including the major areas of concern such as capital adequacy and liquidity risk. This set of Guiding Principles complements various international publications related to liquidity risk management many of which were revised following the financial crisis issued by, inter alia, the Basel Committee on Banking Supervision (BCBS), the Committee of European Banking Supervisors (CEBS) 6 and the International Organization of Securities Commissions (IOSCO). Most importantly, the initiative by the BCBS to develop two international liquidity standards 7 as part of a global regulatory toolkit is a significant development in this respect. The IFSB is working on the preparation of a separate Guidance Note on quantitative tools for the measurement and monitoring of liquidity risk in IIFS, in line with industry practices and other global initiatives, including the Basel III liquidity standards. 8. The IFSB recognises that the specific risk management practices of IIFS may vary in nature and scope depending on the institution size, the products offered and the regulatory environment. Since the financial crisis, a number of IIFS have already made improvements in the liquidity risk management framework of their institutions. 8 Nonetheless, IIFS are expected to make a thorough evaluation of their liquidity risk management practices based on the Guiding Principles, and to make changes/improvements where required. The regulatory/supervisory authorities are also expected to review their current related regulations and guidelines for IIFS, if any, in the light of the principles delineated in these Guiding Principles. 4 IFSB-5 defined Islamic windows as part of a conventional financial institution (which may be a branch or dedicated unit of that institution) that provides fund management (investment accounts) as well as financing and investment that are Sharī`ah compliant. Thus, these windows are potentially self-contained in terms of Sharī`ah-compliant financial intermediations, as the funds generated are invested in Sharī`ah-compliant assets. 5 Supervisory authorities may, at their discretion, extend the application of these Guiding Principles to other financial institutions which mobilise funds on a Sharī`ah-compliant basis and are similar to banks but are not classified as banks by the authorities. Examples are various types of development financial institutions operating in a number of jurisdictions, etc. 6 The CEBS, an advisory group on banking supervision in the European Union, is succeeded by the European Banking Authority (EBA) since 1 January The first liquidity standard is called the Liquidity Coverage Ratio (LCR), which is aimed at promoting short-term resilience of a bank s liquidity risk profile by ensuring that it has sufficient high-quality liquid resources to survive an acute stress scenario lasting for one month. The second standard is called the Net Stable Funding Ratio (NSFR) which is intended to provide a sustainable maturity structure of assets and liabilities over a time horizon of one year. According to the BCBS, the LCR and NSFR will be introduced starting January 2015 and January 2018, respectively. 8 An IFSB survey conducted during the preparation of this standard identified that more than 60% of the IIFS have made a number of changes in their liquidity risk management strategy in the last three years, including: diversification of funding sources; more active involvement of executive management; review of exposure limits for interbank transactions; increasing liquidity buffer, etc. 2

11 9. IIFS also need to recognise that, like other areas of risk management, liquidity risk and asset liability management (ALM) should be integrated with their enterprise risk management (ERM) systems and overall stress testing frameworks. For this purpose, IIFS will be expected to implement enhanced data management processes which can provide accurate risk intelligence to senior management and various business units across the IIFS. As a part of the ERM framework, the interaction of liquidity risk with other types of risks should be monitored by the IIFS, while providing a real-time reporting capability to various stakeholders. Further, relevant personnel in various business units that have the potential to generate liquidity exposure for an IIFS should be fully aware of the consequential impact of their business decisions on the institution s liquidity. 1.3 Implementation Timeline 10. Supervisory authorities are expected to start implementation of these Guiding Principles in their jurisdictions from 2013, taking into account an adequate period for the Guiding Principles to be transformed into national supervisory regulations and guidelines for IIFS, as well as to be incorporated into their own processes of supervising and monitoring these institutions. Such implementation shall be undertaken in compliance with Sharī`ah and within the legal and regulatory framework applicable in the jurisdiction. The application should also be commensurate with the nature, size and complexity of relevant IIFS in the jurisdiction. 1.4 Previous IFSB Publications and Initiatives 11. IFSB-1 (Guiding Principles of Risk Management for IIFS), issued in December 2005, provided a set of guidelines and best practices for establishing and implementing effective risk management in IIFS. This standard identified liquidity risk as one of the six important risks being faced by the IIFS and has outlined two principles in this respect. It has also included guidance for supervisory authorities in order to ascertain that IIFS in their jurisdiction have adequate liquidity policies, systems and controls in place to manage their liquidity risks. Simultaneously, it has emphasised the role of supervisory authorities in providing lender of last resort (LOLR) facilities to IIFS on a Sharī`ah-compliant basis. 12. The IFSB, in collaboration with the Islamic Development Bank (IDB) and Islamic Research & Training Institute (IRTI), published Islamic Financial Services Industry Development: Ten-Year Framework and Strategies in May 2007 (hereinafter the Framework ). The Framework had the aim of supporting the national supervisory authorities in designing IFSI development initiatives and integrating these into their national financial sector development policies. The Framework which has separately addressed issues related to banks, non-bank financial institutions, micro-finance institutions, Takāful institutions, Islamic capital markets and Islamic financial architecture notes that the Islamic banking segment urgently requires Sharī`ah-compliant instruments to meet a number of pressing needs, including the short-term placement of funds and managing liquidity and asset liability mismatches; financial risk management and hedging; resource mobilisation at a competitive cost; and balance sheet management through securitisation. The Framework suggests that IIFS should invest more in their research and development activities in order to introduce new Sharī`ah-compliant instruments. The Framework also outlines the need for the development of a well-functioning Islamic money market. It suggests replicating the success of asset-based securitisation transactions in the conventional capital market to structure more innovative tradable and liquid short-term Islamic financial instruments for the purpose of monetary operations of central banks/monetary authorities, as well as for the liquidity management of IIFS. 13. In March 2008 the IFSB also issued a Technical Note on Issues in Strengthening the Liquidity Management of IIFS: The Development of Islamic Money Markets (TN-1). Inter alia, TN-1 identified and highlighted key issues in strengthening liquidity management by IIFS in a dual banking system, including the practices of central banks in conducting monetary operations with IIFS, and in supporting money market liquidity for both IIFS and conventional banks. TN-1 also outlined several critical areas for development and proposed a comprehensive strategy for the development of Islamic money and government securities markets as the foundation for the broader development of Islamic financial markets. 3

12 14. In October 2008, the IDB formed a Joint IFSB-IRTI-IDB Task Force on Islamic Finance and Global Financial Stability to examine the key elements in Islamic finance that contribute to its viability and resilience, and to review the advancement of the IFSI in the face of the challenges of the current global environment. The Task Force produced the Report on Islamic Finance and Global Financial Stability in April 2010, recommending eight important building blocks to further strengthen the foundations of the Islamic financial system. Three major elements or building blocks identified, inter alia, in this report relate to the development of prudential standards and a supervisory framework for IIFS, addressing related liquidity management issues. These building blocks are: i) developing a set of comprehensive, cross-sectoral prudential standards and a supervisory framework covering Islamic banking, Takāful and the capital market, which take into account the specificities of IIFS; ii) enhancing the financial resilience and stability of the IFSI by the development of a robust national and international liquidity infrastructure, which encompasses the potential for monetary policy and money market operations; and iii) strengthening the financial safety net mechanism namely, LOLR facilities and emergency financing mechanisms as well as deposit insurance, all of which need to be compatible with Sharī`ah principles. 15. In March 2009, the IFSB set up a High-Level Task Force on Liquidity Management. The work of the HLTF builds on one of the key recommendations made in TN-1 namely, that country experiences should be reviewed, and action plans for implementing a money market development strategy in individual countries should be developed. One of the identified issues is the unavailability of sufficient securitisable assets for regular benchmark issues which constrains effective liquidity management by the IIFS. Therefore, the HLTF developed a proposal for international and regional cooperation in acquiring a large pool of securitisable assets as the basis for issuing high-quality benchmark inter-governmental Sukūk that can be traded globally and bring about regional and global integration of Islamic money and capital markets in sovereign issues. After a series of meetings, a number of central banks/monetary authorities and multilateral development banks agreed to establish the International Islamic Liquidity Management Corporation (IILM) in October The IILM will endeavour to achieve the following objectives: (a) facilitate cross-border liquidity management among the IIFS by making available a variety of Sharī`ah-compliant instruments to suit the varying liquidity needs of IIFS; and (b) foster regional and international cooperation in order to build a robust liquidity management infrastructure at the national, regional and international levels. The IILM will procure Sharī`ah-compliant assets or property from members and create a pool to facilitate the issuance of Sukūk or other Sharī`ah-compliant financial instruments. This pool of assets or property will be used by IILM to issue high-quality Sukūk or other Sharī`ah-compliant financial instruments that will facilitate liquidity management by the IIFS and spur the establishment of vibrant local and cross-border Islamic money markets. 4

13 SECTION II: LIQUIDITY RISK AND NECESSARY ELEMENTS FOR ITS EFFECTIVE MANAGEMENT IN THE IFSI 2.1 Liquidity Risk and Liquidity Risk Management 17. Liquidity risk is the potential loss to IIFS arising from their inability either to meet their obligations or to fund increases in assets as they fall due without incurring unacceptable costs or losses. 9 Liquidity risk can be categorised into two major types: funding and market liquidity risk. Funding liquidity risk is the risk that an IIFS will not be able to meet efficiently both its expected and unexpected current and future cash flow and collateral needs without affecting either daily operations or the financial condition of the IIFS. Market liquidity risk is the risk that an IIFS cannot easily offset or eliminate a position at the market price because of inadequate market depth or market disruption Liquidity risk can arise due to funding or market risk, or various factors arising due to a combination of these risks, which might be linked to changes in institutional or systemic behaviour. An IIFS may face funding liquidity risk due to unexpected withdrawals or transfers of funds by its investment account holders (IAH) and depositors for several reasons, including reduced creditworthiness, displaced commercial risk, Sharī`ah non-compliance risk or reputational risk. On the assets side, an IIFS may face funding strain due to problems in its financing and investment portfolio for example, a fall in value of marketable assets held for trading or in the banking book, lack of liquid markets for holdings of Sukūk 11 and other Sharī`ah-compliant instruments, the impairment of Islamic financing assets due to the financial distress of customers, and large drawdowns under committed line-of-credit agreements. An IIFS may also face increased liquidity risk due to operational and information system failures of counterparties, or because of problems in a payment and settlement system resulting in late payment or non-payment of funds due. 19. Bearing in mind the strong interactions between funding and market liquidity risk, these Guiding Principles provide various insights into both funding and market liquidity risk in IIFS and their correlations. The Guiding Principles also elaborate the role of supervisory authorities in providing a necessary framework and complementing it with regulatory guidelines for enhancing market liquidity for IIFS. In order to meet the shortfall in funding liquidity, an IIFS can opt to sell its assets in the Islamic money market. In this way, funding liquidity risk is mitigated through raising cash by the selling of assets. Insufficient market depth due to the lack of an adequate number of players, as well as the insufficient quantity and volume of instruments in the market can make it difficult for an IIFS to generate cash by selling assets, thus contributing to an increased funding liquidity risk. In stressed conditions, deterioration in market liquidity may either impact the liquidity of a particular type of instrument or affect a wide range of assets in the market. 20. All other risks of an IIFS culminate in liquidity stress before ultimately resulting in insolvency. An IIFS could fail if its cash inflows from new investment accounts and deposits, repayment of financing, sale of assets and mobilisation of new funds are unable to meet its cash outflow obligations such as mandatory cash reserves, investment account and deposit withdrawals, operating expenses and payments to creditors. From a funding liquidity risk perspective, two main sources of generating the funds available to conventional banks are not applicable to the IIFS. An IIFS cannot take an interest-based loan from the interbank market or other sources, and in most jurisdictions it is not allowed to transfer its debt, other than at its face value. Shortage or unavailability of Sharī`ah-compliant securities in many jurisdictions adds to these problems, compelling IIFS to maintain a higher level of cash and non-earning liquid assets than conventional institutions. These factors affect the performance and competitiveness of IIFS vis-à-vis conventional financial institutions in several jurisdictions. 9 See IFSB-1, paragraph BCBS Principles for Sound Liquidity Risk Management and Supervision, footnote Sharī`ah-compliant instruments and Sukūk have been used interchangeably in the Standard. 5

14 2.2 Necessary Elements of Effective Liquidity Risk Management in the IFSI 21. The term liquidity infrastructure refers to a set of key institutional and operational arrangements which in any jurisdiction can provide a facilitating environment to financial institutions in that jurisdiction for managing their liquidity in normal and stressed times, as well as supporting market liquidity in the system. The components of a balanced liquidity infrastructure are largely institutional in nature. These infrastructure elements may or may not be within the scope of the authority of the supervisory authority. Nevertheless, supervisory authorities should communicate to the relevant state authorities and institutions the actual and potential negative repercussions of not providing a facilitating atmosphere to IIFS for managing their liquidity in an effective and competitive manner and thus ensuring the soundness and stability of IFSI as well as of the financial sector as a whole. Supervisory authorities may also liaise with relevant state authorities and institutions by providing the necessary technical support and assisting in finding appropriate solutions for IFSI. 22. The existence of a robust liquidity risk management infrastructure for IIFS is increasingly viewed as an essential component of both Islamic financial market development and overall financial system stability. The liquidity infrastructure for IIFS is composed of a number of elements, as follows: i) a system of business laws, including securities, capital market, trust, public debt, contract, bankruptcy and asset recovery laws; ii) adequate macroprudential surveillance in order to monitor the impact of potential macroeconomic shocks on financial soundness, and to adjust macro and financial policies as and when required; iii) a secure and efficient payment and clearing system; iv) a regime for timely and relevant information disclosures to various stakeholders of IIFS including IAH in order to ensure transparency and effective market discipline; v) a broad framework governing applicable Islamic financial transactions, including appropriate governance in place to ensure compliance with Sharī`ah rules and principles; 12 vi) a well-functioning Islamic money market and a sufficient number of Sharī`ah-compliant instruments, players and channels; vii) a carefully designed mechanism for providing an appropriate level of systemic protection that is, a public safety net; viii) the availability of monetary policy instruments and mechanisms in compliance with Sharī`ah ix) rules and principles; a vibrant and well-managed exchange and securities market in Sharī`ah-compliant government and corporate instruments; x) a framework for dealing with insolvency by IIFS, and associated rules, rights and obligations for recovery of financing and that of parties to the transaction, including investors, financers, shareholders and depositors; 13 xi) the availability of suitable Islamic benchmarks for transacting and pricing the financial products offered by IIFS on the basis of various Sharī`ah-compliant modes of financing and investment; xii) application of internationally recognised accounting and auditing standards to facilitate accuracy, reliability, timeliness and comparability of the information disclosed by IIFS; and xiii) the availability of external credit assessment institutions and other information intermediaries (investment advisers, investment research firms, credit bureaus, financial journalists, etc.) to facilitate effective disclosures and enhance market discipline. 23. IIFS, like their conventional counterparts, are involved in maturity transformation by accepting short-term deposits and investment accounts and providing financing mainly on a medium- to long-term basis. This maturity transformation process entails a number of risks for an IIFS, including liquidity risk. Commonly, major risks faced by conventional financial institutions are managed through instruments that offer opportunities to hedge and transfer the risk, financial markets that make available other 12 See IFSB-5, paragraph A feature of bankruptcy or insolvency laws includes close-out netting provisions. 6

15 counterparties for funding positions for desired maturities, and an enabling payment and settlement system that provides a platform for clearance and processing of payments across the financial institutions. There are a number of shortcomings faced by the IFSI in terms of various components of a liquidity infrastructure for IIFS, as described earlier. In many jurisdictions, there is a shortage or unavailability of a supporting liquidity infrastructure in terms of market players, Sharī`ah-compliant instruments and associated interbank, money and secondary markets. Likewise, conditions may not exist for ensuring the effectiveness of a Sharī`ah-compliant LOLR facility and Sharī`ah-compliant deposit insurance. In addition, there is typically a lack of a well-functioning insolvency regime for IIFS. 24. The availability of the infrastructure elements at the jurisdiction level 14 (as mentioned in paragraph 22) not only provides a level playing field for IIFS making them more sound, competitive and in tune with the international legal and regulatory environment but also fosters avenues for international cooperation and the expansion of IIFS. It will also help IIFS to reduce their cost of intermediation, enhance the level of liquidity in the system, and improve their profitability by removing obstacles to the effective management of liquidity risk and the deployment of liquid funds in the market. From a macroprudential stability viewpoint, these necessary building blocks will enhance the ability of an IIFS to meet expected and unexpected cash-flow obligations, thus reducing the possibility of liquidity shortfalls and systemic contagion across the financial markets. 14 Though efforts to build liquidity infrastructure for IFSI should start at the level of relevant jurisdiction, efforts at the international level can equally support this cause. 7

16 2.3 Executive Summary of the Guiding Principles GENERAL PRINCIPLE Principle 1: An IIFS should have in place a sound and comprehensive liquidity risk management framework, integrated into its enterprise risk process, in order to maintain sufficient liquidity to meet its daily funding needs and to cover both expected and unexpected deviations from normal operations for a reasonable time. The IIFS should have an appropriate governance process, including board and senior management oversight, in order to identify, measure, monitor, report and control the liquidity risk in compliance with Sharī`ah rules and principles and within the context of available Sharī`ah-compliant instruments and markets. Supervisory authorities should have a rigorous process for evaluating the liquidity risk management position and framework of IIFS and requiring prompt corrective action in case of any deficiency. GUIDING PRINCIPLES FOR THE IIFS Role of the Board of Directors Principle 2: The Board of Directors has the ultimate responsibility for setting the level of liquidity risk to be incurred (the liquidity risk tolerance) and the liquidity risk management framework of the IIFS. Therefore, it should establish a level of liquidity risk tolerance for the IIFS commensurate with its ability to have sufficient recourse to Sharī`ah-compliant funds in order to mitigate this risk. In line with the stated risk tolerance, the board should establish, approve and review from time to time the liquidity risk management strategy and significant policies, taking into consideration the IIFS s business model, legal structure, complexity, key lines of business, and macroeconomic and regulatory environment. Governance Structure and the Role of Senior Management Principle 3: The governance structure of IIFS should specify the roles and responsibilities of senior management, the Sharī`ah supervisory board, as well as various functional and business units, including that of the risk management department, with appropriate segregation between operational and monitoring functions. The senior management of the IIFS has responsibility for executing the liquidity risk management strategy and policies approved by the board in an integrated manner, while ensuring that liquidity is effectively managed on a regular and timely basis and that appropriate policies and procedures are established to limit and control material sources of liquidity risk. Identification of Liquidity Risk Principle 4: An IIFS should be able to identify all sources of primary and secondary risks whether idiosyncratic, market-wide or cross-border that can lead to and interact with its liquidity risk. In particular, the IIFS should be able to model the contractual as well as the behavioural profiles of its investment account holders (IAH), current account holders and other fund providers, in normal and stressed market conditions. In doing so, the IIFS should take account of the effects of any smoothing practices it has adopted in making profit payouts to its IAH, and its possible access to Sharī`ah-compliant deposit insurance. Interactions of Liquidity Risk and Implications of Islamic Financing Contracts Principle 5: The IIFS should ensure that liquidity risk management practices are incorporated within a firm-wide, integrated enterprise risk management framework that fully takes into account the interactions between liquidity risk and other risks, including market, credit and operational risk, displaced commercial risk, reputational and Sharī`ah non-compliance risk. This framework should also address liquidity risk arising from various Sharī`ah-compliant financial contracts, either directly due to the nature of the contract or indirectly as a consequence of other risks at any stage during the period of the contract. Measurement of Liquidity Risk Principle 6: An IIFS should be able to measure and forecast its prospective cash flows arising from onand off-balance sheet positions over a variety of appropriate time horizons in different currencies and market conditions, using suitable metrics and methodologies including deterministic, behavioural and 8

17 statistical modelling, where appropriate. The results of these calculations, along with suitable stress testing and scenarios analysis, should provide a basis for setting thresholds and limits, as well as for making any adjustments in the liquidity risk management strategy, policies and procedures. Control and Mitigation of Liquidity Risk (Principles 7-13) Diversified Funding Base Principle 7: An IIFS should ensure that it has a well-diversified funding base that is commensurate with the nature and size of its business, products offered and market environment. Such diversification should address potential concentrations by providers of liquidity (retail or wholesale), funding types (secured or unsecured), maturity profile, currencies and geographical locations. The IIFS should test, on a regular basis, its ability to raise funds from each funding source, and make appropriate adjustments in its diversification strategies in anticipation of changes in its internal and external environment. The potential funding base may include, where appropriate, Sharī`ah-compliant securitisation. Consolidated Management of Liquidity Risk Principle 8: If an IIFS is part of a financial group (e.g. a fully fledged Islamic bank or Islamic investment bank) or part of a conventional bank (e.g. an Islamic window operation) which has a centralised structure for managing liquidity risk, the board and senior management at the group/parent level should prepare a strategy, policies and procedures for the Islamic operations taking into account the position of such operations within the overall group/parent, with due consideration to the mutual independencies and constraints in transfers of liquidity on a Sharī`ah-compliant basis between the group entities. Maintaining High-Quality Liquidity Buffer Principle 9: An IIFS should maintain a liquidity buffer, composed of cash and other highly liquid Sharī`ahcompliant assets, in order to withstand a prolonged period of potential stress conditions. There should be minimal legal, regulatory or operational obstacles to the sale or pledge of such assets in order to generate funding in a variety of market stress situations. The magnitude and composition of these assets should be in line with the IIFS s risk tolerance and its liquidity requirements as estimated by its stress testing exercises. Preparing a Contingency Funding Plan Principle 10: All IIFS, regardless of their nature and complexity, should have a contingency funding plan that delineates the action plan and procedures for dealing with liquidity stress events. Such a plan should be prepared with input from all relevant functions of the IIFS, while carefully incorporating the results from stress tests, including scenario analyses. The plan should establish a clear designation of roles and responsibilities and backup of key functions, with a suitable internal and external communication plan addressing various stages of stress events. The plan should include regular monitoring of related triggers, with appropriate escalation procedures. It should be reviewed as the business and market environment changes. Managing Sharī`ah-Compliant Collateral Principle 11: An IIFS should be able to identify its needs for Sharī`ah-compliant collateral over different time horizons, and should address the Sharī`ah, legal and operational constraints on the use of such collateral. The IIFS should actively manage its collateral positions while differentiating between encumbered and unencumbered assets, and its information system should be able to identify available unencumbered collateral by type, currency and location, in both normal and stressed times. Collaboration between IIFS Principle 12: With due attention to the lack of well-developed Islamic interbank markets for effective liquidity risk management in a number of jurisdictions, IIFS should closely cooperate among themselves in order to develop Sharī`ah-compliant arrangements, solutions and trading mechanisms for liquidity management purposes. Such collaboration may involve Islamic banking industry associations in the jurisdiction. These and other arrangements may be supported by the supervisory authorities in order to provide a robust platform and harmonised agreements for active trading between the IIFS, with availability of market makers in various trading instruments and mechanisms. 9

18 Meeting Payment and Settlement System Obligations Principle 13: Irrespective of whether an IIFS uses a net or a gross payment and settlement system, it should be able to manage short-term (overnight and intraday) liquidity in order to meet on a timely basis its payment and settlement obligations in all circumstances. In view of the interdependencies and interconnectedness between payment and settlement systems, an IIFS should ensure that its critical payments are always made on a timely basis in order to avoid any potential systemic disruptions which could prevent the smooth functioning of other payment systems and money markets. Foreign Exchange Liquidity Risk Principle 14: An IIFS should have a measurement, monitoring and control mechanism for liquidity positions in each currency with a significant exposure. An IIFS should assess, monitor and, where appropriate, limit the size of its cash-flow mismatches over particular time horizons for foreign currencies in aggregate and for each significant individual currency in which it operates, especially with respect to its domestic currency (or, where different, its functional currency). The IIFS should employ appropriate stress tests and make use of Sharī`ah-compliant hedging strategies for limit setting and controlling currency risk. The IIFS should especially limit its exposures in currencies that are not highly liquid or have low convertibility. Reporting and Disclosure of Liquidity Risk Principle 15: An IIFS should have a fully integrated information system, commensurate with its nature, size and complexity of operations, that provides clear, timely and accurate liquidity risk reports to its relevant functional units and senior management. The information system should, at suitable intervals, present to senior management and the board a clear understanding of the IIFS s liquidity risk exposures, its compliance with established policies and limits, as well as the appropriateness of management strategies with respect to approved risk tolerance. The IIFS should make appropriate and regular disclosures of qualitative and quantitative information about its liquidity position and liquidity risk management practices through suitable channels. GUIDING PRINCIPLES FOR SUPERVISORY AUTHORITIES Responsibility for Supervision of Liquidity Risk and Position Principle 16: Supervisory authorities should make a regular evaluation of the overall liquidity positions and the liquidity risk management framework of an IIFS so as to ensure that it maintains an adequate level of liquidity at all times, and can withstand a period of liquidity stress. As a part of supervisory assessment, special emphasis should be given to the application of appropriate stress tests, the composition and robustness of liquidity buffers, and the effectiveness of contingency funding plans. Need for Supervisory Regulations for IIFS Principle 17: Supervisory authorities should develop regulations and guidelines for management of liquidity risk by IIFS, taking into account their specificities related to funding structure, financing and investment products, access to Sharī`ah-compliant securities, as well as the stage of development of the Islamic money market in their jurisdiction. Supervisors Role as Provider of Liquidity Support Principle 18: Supervisory authorities should provide maximum clarity of their roles as provider of liquidity support, in compliance with the Sharī`ah, in both normal and stressed times, simultaneously seeking to harmonise and expand the eligibility of Sharī`ah-compliant collateral for providing such liquidity support to IIFS. Supervision of Liquidity Risk at Consolidated Level Principle 19: In cases where fully fledged Islamic banks are part of a financial group, or where a conventional bank offers Islamic operations through Islamic windows, supervisory authorities should fully evaluate the liquidity risk management framework at both the group/parent level and Islamic entity level. The supervisory authorities should ensure that there is sufficient liquidity at both the levels to meet the 10

19 funding needs during normal and stressed times. Supervisory authorities should also ensure that risk of liquidity and reputational contagion from Islamic to other operations, or vice versa, has been properly considered and suitably mitigated. Compilation of Information about Liquidity and Corrective Action Principle 20: Supervisory authorities should require the IIFS to submit precise and timely qualitative and quantitative information to evaluate the liquidity risk profile and framework adopted by the IIFS in their jurisdiction. If the supervisory authority becomes aware of any major shortcomings in the liquidity position or liquidity risk management framework of an IIFS, it should require the IIFS to take timely corrective action to address the detected problems. Supervisory authorities should make use of various tools at their disposal, with appropriate escalation procedures, for ensuring that suitable corrective action is taken by the IIFS. Home-Host and Cross-Sector Supervision of Liquidity Risk Principle 21: For IIFS having cross-border operations, home and host supervisory authorities should collaborate, communicate and agree on their assessments of the consolidated liquidity position and the framework for managing liquidity risk by the respective entities. Through mutual cooperation, home and host supervisory authorities should take measures which can protect their financial systems against any liquidity contagion due to idiosyncratic or market-wide stress situations. Supervisory authorities within a jurisdiction that monitor different business lines of IIFS should also take steps for coordinated supervision and information sharing on the liquidity positions and levels of risk of these entities. Supervisors Contingency Planning for the IIFS Principle 22: Supervisory authorities should have a plan for identifying and dealing with liquidity stress in the IIFS sector as a part of their macroprudential liquidity contingency framework for the financial sector. Such a framework should be supported by macro-level stress testing by the supervisory authorities, taking into consideration the balance sheet exposures submitted by IIFS as well as other relevant macroeconomic, geographic and political factors. Supervisors Role in the Development of Liquidity Infrastructure Principle 23: In order to provide a conducive environment for liquidity risk management by the IIFS, supervisory authorities should work closely with other relevant official or public sector bodies (e.g. the finance ministry and the deposit insurance provider) to facilitate the issuance of Sharī`ah-compliant instruments/sukūk by the government and the provision of Sharī`ah-compliant deposit insurance. Supervisory authorities, together with other relevant bodies, should facilitate the availability of market makers in Sharī`ah-compliant instruments/sukūk in their jurisdictions so as to develop secondary markets in such instruments and to increase market liquidity. 11

20 SECTION III: GENERAL AND GUIDING PRINCIPLES FOR THE IIFS 3.1 General Principle Principle 1 An IIFS should have in place a sound and comprehensive liquidity risk management framework, integrated into its enterprise risk process, in order to maintain sufficient liquidity to meet its daily funding needs and to cover both expected and unexpected deviations from normal operations for a reasonable time. The IIFS should have an appropriate governance process, including board and senior management oversight, in order to identify, measure, monitor, report and control the liquidity risk in compliance with Sharī`ah rules and principles and within the context of available Sharī`ah-compliant instruments and markets. Supervisory authorities should have a rigorous process for evaluating the liquidity risk management position and framework of IIFS and requiring prompt corrective action in case of any deficiency. 25. An IIFS should have a sound and comprehensive liquidity risk management framework as a part of its enterprise risk process. The main objective of this framework should be to maintain sufficient liquidity to meet its regular funding requirements and payment obligations in the normal course of business, and to help it withstand a reasonable period of liquidity stress based on its liquidity tolerance level. The liquidity risk management process of an IIFS should involve adequate tools to identify, measure, monitor, report and control the liquidity risk in compliance with Sharī`ah rules and principles, including a plan to meet contingency funding requirements and setting of limits on the basis of robust stress testing and scenario analysis. 26. The ultimate responsibility for providing a comprehensive liquidity risk management framework, and for monitoring the level of liquidity risk maintained by the IIFS, lies with its board of directors 15 (hereinafter to be referred as the board ). This framework should include strategy and significant policies for management of liquidity risk by the IIFS, keeping in view the nature and size of its operations, business model, funding profile, mix of Sharī`ah-compliant financing and investment products, availability of Sharī`ah-compliant liquidity instruments and mechanisms in the jurisdiction, and liquidity support available from supervisory authorities 16 on a Sharī`ah-compliant basis. Senior management is responsible for executing and implementing the board-approved strategy and policies for managing the liquidity risk, for having a clear view of all sources and linkages of liquidity risks by taking a holistic approach to risk management, and for laying down the procedures and processes for continuous monitoring of liquidity risk and reporting to the board. 15 The term board of directors has been used in these Guiding Principles not to identify a legal construct but rather to label a top decision-making function within an IIFS (or other entity). In a single-tier system, such as those in most IFSB member countries, the board of directors includes both non-executive and executive directors, and plays the role of a monitoring and supervisory organ assisted by certain key committees with the non-executive directors representing shareholders and other outside interests, and the executive directors heading at least some of the top executive functions. In jurisdictions that adopt a two-tier system, this system comprises a supervisory board" and a "management (or executive) board". In the latter system, the supervisory board includes only non-executive directors, and is charged with the monitoring and supervision of the management (or executive) board. The management (or executive) board, on the other hand, includes the members of senior management heading the top executive functions, being charged with the management of the entity, and being accountable to the supervisory board. Another main difference between the single and dual systems is that in the former, executive management powers are delegated by the board of directors and can theoretically be changed at any time, whereas the powers of the management (or executive) board in a dual system are mostly vested by law and cannot be reduced even by a shareholders' resolution on amendments to the Articles. References to the board of directors in these Guiding Principles are to be understood as designating the body that is charged with the top executive functions in the entity namely, the board of directors in a single-tier system and the management or (executive) board in a dual-tier system. References to senior management designate the heads of the main executive functions in the entity in their functional capacities, rather than as members of a top executive body. 16 The term supervisory authority in these Guiding Principles has been used in a general sense to refer to the institution which is responsible for supervising the operations of IIFS in that jurisdiction. In this context, this term may refer to the central bank, monetary authority, financial supervisor, Ministry of Finance or other overseer of the operations of the IIFS in a jurisdiction depending on the structure of the financial supervisory system in the relevant jurisdiction. 12